Who Regulates Whom? An Overview of U.S. Financial Supervision

Who Regulates Whom? An Overview of U.S. Financial Supervision

Mark Jickling Specialist in Financial Economics Edward V. Murphy Specialist in Financial Economics

December 8, 2010

CRS Report for Congress

Prepared for Members and Committees of Congress

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Who Regulates Whom? An Overview of U.S. Financial Supervision

Summary

This report provides an overview of current U.S. financial regulation: which agencies are responsible for which institutions, activities, and markets, and what kinds of authority they have. Some agencies regulate particular types of institutions for risky behavior or conflicts of interest, some agencies promulgate rules for certain financial transactions no matter what kind of institution engages in it, and other agencies enforce existing rules for some institutions, but not for others. These regulatory activities are not necessarily mutually exclusive.

There are three traditional components to U.S. banking regulation: safety and soundness, deposit insurance, and adequate capital. The Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) added a fourth: systemic risk. Safety and soundness regulation dates back to the 1860s when bank credit formed the money supply. Examinations of a bank's safety and soundness is believed to contribute to a more stable broader economy. Deposit insurance was established in the 1930s to reduce the incentive of depositors to withdraw funds from banks during a panic. Banks pay premiums to support the deposit insurance fund, but the Treasury provides full faith and credit for covered deposits if the fund were to run short. Deposit insurance is a second reason that federal agencies regulate bank operations, including the amount of risk they may incur. Capital adequacy has been regulated since the 1860s when "wildcat banks" sought to make extra profits by reducing their capital reserves, which increases their risk of default and failure. Dodd-Frank created the interagency Financial Stability Oversight Council (FSOC) to monitor systemic risk and consolidated bank regulation from five agencies to four. For banks and non-banks designated by the FSOC as creating systemic risk, the Federal Reserve has oversight authority, and the Federal Deposit Insurance Corporation (FDIC) has resolution authority.

Federal securities regulation has traditionally been based on the principle of disclosure, rather than direct regulation. Firms that sell securities to the public must register with the Securities and Exchange Commission (SEC), but the agency generally has no authority to prevent excessive risk taking. SEC registration in no way implies that an investment is safe, only that the risks have been fully disclosed. The SEC also registers several classes of securities market participants and firms. It has enforcement powers for certain types of industry misstatements or omissions and for certain types of conflicts of interest. Derivatives trading is supervised by the Commodity Futures Trading Commission (CFTC), which oversees trading on the futures exchanges, which have selfregulatory responsibilities as well. Dodd-Frank has required more disclosures in the previously unregulated over-the-counter (off-exchange) derivatives market and has granted the CFTC and SEC authority over large derivatives traders.

The Federal Housing Finance Agency (FHFA) oversees a group of government-sponsored enterprises (GSEs)--public/private hybrid firms that seek both to earn profits and to further the policy objectives set out in their statutory charters. Two GSEs, Fannie Mae and Freddie Mac, were placed in conservatorship by the FHFA in September 2008 after losses in mortgage asset portfolios made them effectively insolvent.

Dodd-Frank consolidated consumer protection rulemaking, which had been dispersed among several federal agencies in a new Bureau of Consumer Financial Protection. The bureau is intended to bring consistent regulation to all consumer financial transactions, although the legislation exempted several types of firms and transactions from its jurisdiction.

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Who Regulates Whom? An Overview of U.S. Financial Supervision

Contents

Introduction ................................................................................................................................1 What Financial Regulators Do.....................................................................................................1 Banking Regulation ....................................................................................................................6

Safety and Soundness Regulation..........................................................................................6 Deposit Insurance .................................................................................................................7 Capital Regulation ................................................................................................................7 Systemic Risk .......................................................................................................................8 Capital Requirements ..................................................................................................................8 Basel III ................................................................................................................................9 Capital Provisions in Dodd-Frank ....................................................................................... 10 Non-Bank Capital Requirements ......................................................................................... 12

The SEC's Net Capital Rule .......................................................................................... 12 CFTC Capital Requirements ......................................................................................... 12 Federal Housing Finance Agency .................................................................................. 13 The Federal Financial Regulators .............................................................................................. 14 Banking Regulators............................................................................................................. 14 Office of the Comptroller of the Currency ..................................................................... 15 Federal Deposit Insurance Corporation.......................................................................... 15 The Federal Reserve...................................................................................................... 16 Office of Thrift Supervision (Abolished by Dodd-Frank)............................................... 17 National Credit Union Administration ........................................................................... 18 Non-Bank Financial Regulators........................................................................................... 18 Securities and Exchange Commission ........................................................................... 18 Commodity Futures Trading Commission ..................................................................... 21 Federal Housing Finance Agency .................................................................................. 21 Bureau of Consumer Financial Protection ..................................................................... 22 Regulatory Umbrella Groups............................................................................................... 23 Financial Stability Oversight Council ............................................................................ 23 Federal Financial Institution Examinations Council....................................................... 24 President's Working Group on Financial Markets .......................................................... 24 Unregulated Markets and Institutions ........................................................................................ 25 Foreign Exchange Markets.................................................................................................. 25 U.S. Treasury Securities ...................................................................................................... 25 Private Securities Markets................................................................................................... 26 Comprehensive Reform Legislation in the 111th Congress ................................................... 26

Figures

Figure A-1. National Bank ........................................................................................................ 28 Figure A-2. National Bank and Subsidiaries .............................................................................. 28 Figure A-3. Bank Holding Company ......................................................................................... 29 Figure A-4. Financial Holding Company ................................................................................... 29

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Who Regulates Whom? An Overview of U.S. Financial Supervision

Tables

Table 1.Federal Financial Regulators and Who They Supervise ...................................................4 Table 2.The Basel Accords: Risk Weightings for Selected Financial Assets Under the

Standardized Approach ............................................................................................................9 Table 3.Capital Standards for Federally Regulated Depository Institutions................................. 11

Appendixes

Appendix A. Forms of Banking Organizations........................................................................... 28 Appendix B. Bank Ratings: UFIRS and CAMELS .................................................................... 30 Appendix C. Acronyms ............................................................................................................. 32 Appendix D. Regulatory Structure Before the Dodd-Frank Act.................................................. 33 Appendix E. Glossary of Terms................................................................................................. 34

Contacts

Author Contact Information ...................................................................................................... 41 Acknowledgments .................................................................................................................... 41

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Who Regulates Whom? An Overview of U.S. Financial Supervision

Introduction

Historically, major changes in financial regulation in the United States have often come in response to crisis. Thus, it is no surprise that the turmoil beginning in 2007 led to calls for reform. Few would argue that regulatory failure was solely to blame for the crisis, but it is widely considered to have played a part. In February 2009, Treasury Secretary Timothy Geithner summed up two key problem areas:

Our financial system operated with large gaps in meaningful oversight, and without sufficient constraints to limit risk. Even institutions that were overseen by our complicated, overlapping system of multiple regulators put themselves in a position of extreme vulnerability. These failures helped lay the foundation for the worst economic crisis in generations.1

In this analysis, regulation failed to maintain financial stability at the systemic level because there were gaps in regulatory jurisdiction and because even overlapping jurisdictions--where institutions were subject to more than one regulator--could not ensure the soundness of regulated financial firms. In particular, limits on risk-taking were insufficient, even where regulators had explicit authority to reduce risk.

This report attempts to set out the basic principles underlying U.S. financial regulation and to give some historical context for the development of that system. The first section briefly discusses the various modes of financial regulation and includes a table identifying the major federal regulators and the types of institutions they supervise. The table also indicates certain emergency authorities available to the regulators, including those that relate to systemic financial disturbances. The second section focuses on capital requirements--the principal means of constraining risky financial activity--and how risk standards are set by bank, securities, and futures regulators.

The next sections provide brief overviews of each federal financial regulatory agency and discussions of several major financial markets that are not subject to any federal regulation.

What Financial Regulators Do

The regulatory missions of individual agencies vary, partly as a result of historical accident. Here is a rough division of what agencies are called upon to do:

? Regulate Certain Types of Financial Institutions. Some firms become subject to federal regulation when they obtain a particular business charter, and several federal agencies regulate only a single class of institution. Depository institutions are a good example: a new banking firm chooses its regulator when it decides which charter to obtain--national bank, state bank, credit union, etc.--and the choice of charter may not greatly affect the institution's business mix. The Federal Housing Finance Authority (FHFA) regulates only three governmentsponsored enterprises: Fannie Mae, Freddie Mac, and the Federal Home Loan

1 Remarks by Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan, February 10, 2009, .

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Who Regulates Whom? An Overview of U.S. Financial Supervision

Bank system. Regulation keyed to particular institutions has at least two perceived disadvantages: regulator shopping, or regulatory arbitrage, may occur if regulated entities can choose their regulator, and unchartered firms engaging in the identical business activity as regulated firms may escape regulation altogether.

? Regulate a Particular Market. The New York Stock Exchange dates from 1793, federal securities regulation from 1934. Thus, when the Securities and Exchange Commission (SEC) was created by Congress, stock and bond market institutions and mechanisms were already well-established, and federal regulation was grafted onto the existing structure. As the market evolved, however, Congress and the SEC faced numerous jurisdictional issues. For example, de minimis exemptions to regulation of mutual funds and investment advisers created space for the development of a trillion-dollar hedge fund industry, which was unregulated until the Dodd-Frank Act.

Market innovation also creates financial instruments and markets that fall between industry divisions. Congress and the courts have often been asked to decide whether a particular financial activity belongs in one agency's jurisdiction or another's.

? Regulate a Particular Financial Activity. When regulator shopping or perceived loopholes appear to weaken regulation, one response is to create a regulator tasked with overseeing a particular type or set of transactions, regardless of where the business occurs or which entities are engaged in it. In 1974, Congress created the Commodity Futures Trading Commission (CFTC) at the time when derivatives were poised to expand from their traditional base in agricultural commodities into contracts based on financial instruments and variables. The CFTC was given "exclusive jurisdiction" over all contracts that were "in the character of" options or futures contracts, and such instruments were to be traded only on CFTC-regulated exchanges. In practice, exclusive jurisdiction was impossible to enforce, as off-exchange derivatives contracts such as swaps proliferated. In 2000, Congress exempted swaps from CFTC regulation, but this exemption was repealed by Dodd-Frank.

On the view that consumer financial protections should apply uniformly to all transactions, the Dodd-Frank Act created a Bureau of Consumer Financial Protection, with authority (subject to certain exemptions) over an array of firms that deal with consumers.

? Regulate for Systemic Risk. One definition of systemic risk is that it occurs when each firm manages risk rationally from its own perspective, but the sum total of those decisions produces systemic instability under certain conditions. Similarly, regulators charged with overseeing individual parts of the financial system may satisfy themselves that no threats to stability exist in their respective sectors, but fail to detect systemic risk generated by unsuspected correlations and interactions among the parts of the global system. The Federal Reserve was for many years a kind of default systemic regulator, expected to clean up after a crisis, but with limited authority to take ex ante preventive measures. DoddFrank creates the Financial Stability Oversight Council (FSOC) to assume a coordinating role, with the single mission of detecting systemic stress before a

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Who Regulates Whom? An Overview of U.S. Financial Supervision

crisis can take hold (and identifying firms whose individual failure might trigger cascading losses with system-wide consequences).

From time to time, the perceived drawbacks to the multiplicity of federal regulators brings forth calls for regulatory consolidation.2 The legislative debate over Dodd-Frank illustrates the different views on the topic: early versions of the Senate bill would have replaced all the existing bank regulators with a single Financial Institution Regulatory Authority. By the end, however, DoddFrank created two new agencies (and numerous regulatory offices), and eliminated only the Office of Thrift Supervision (OTS).

There have always been arguments against regulatory consolidation. Some believe that a fragmentary structure encourages innovation and competition and fear that the "dead hand" of a single financial supervisor would be costly and inefficient. Also, there is little evidence that countries with single regulators fare better during crises or are more successful at preventing them. One of the first proposals by the Conservative government elected in the UK in May 2010 was to break up the Financial Services Authority, which has jurisdiction over securities, banking, derivatives, and insurance.

Table 1 below sets out the federal financial regulatory structure as it will exist once all the provisions of the Dodd-Frank Act become effective. (In many cases, transition periods end a year or 18 months after July 21, 2010, the date of enactment. Thus, OTS does not appear in Table 1, even though the agency will continue to operate into 2011.) Appendix D of this report contains a pre-Dodd-Frank version of the same table. Supplemental material--charts that illustrate the differences between banks, bank holding companies, and financial holding companies--appears in Appendix A.

2 See, e.g., U.S. Department of the Treasury, Blueprint for a Modern Financial Regulatory Structure, March 2008, which called for a three-agency structure: a systemic risk regulator, a markets supervisor, and a consumer regulator.

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Who Regulates Whom? An Overview of U.S. Financial Supervision

Table 1.Federal Financial Regulators and Who They Supervise

Regulatory Agency

Institutions Regulated

Emergency/Systemic Risk Powers

Other Notable Authority

Federal Reserve

Office of the Comptroller of the Currency (OCC) Federal Deposit Insurance Corporation (FDIC)

National Credit Union Administration (NCUA)

Bank holding companiesa and certain subsidiaries, financial holding companies, securities holding companies, savings and loan holding companies, and any firm designated as systemically significant by the FSOC

State banks that are members of the Federal Reserve System, U.S. branches of foreign banks, and foreign branches of U.S. banks

Payment, clearing, and settlement systems designated as systemically significant by the FSOC, unless regulated by SEC or CFTC

National banks, U.S. federal branches of foreign banks, federally chartered thrift institutions

Federally-insured depository institutions, including state banks that are not members of the Federal Reserve System and state-chartered thrift institutions

Federally-chartered or insured credit unions

Lender of last resort to member banks (through discount window lending)

In "unusual and exigent circumstances" the Fed may extend credit beyond member banks, for the purpose of providing liquidity to the financial system, but not to aid failing financial firms

May initiate resolution process to shut down firms that pose a grave threat to financial stability (requires concurrence of 2/3 of the FSOC)

After making a determination of systemic risk, the FDIC may invoke broad authority to use the deposit insurance funds to provide an array of assistance to depository institutions, including debt guarantees

Serves as a liquidity lender to credit unions experiencing liquidity shortfalls through the Central Liquidity Facility

Operates a deposit insurance fund for credit unions, the National Credit Union Share Insurance Fund (NCUSIF)

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